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NASDAQ Trades Its First Ever Senior Loan ETF

NEW YORK (MainStreet)—While less than 1% of all ETF assets are in actively managed products, more players are throwing their hat into the ring, including the NASDAQ. The actively-managed ETF provider First Trust launched the first ever senior loan product on the NASDAQ Stock Market this month called the First Trust Senior Loan Fund (FTSL).

"First Trust's actively managed senior loan fund offers investors an opportunity to access yield while having some protection from the eventual rise in interest rates," said Dave LaValle, vice president of transaction services at NASDAQ OMX.

FTSL meets growing investor demand for leveraged-loan funds, which have been increasing in popularity due to expectations that central banks will raise interest rates in the next few years.

But unlike a high yield bond that has a fixed interest rate, senior loans pay a floating interest rate.

"We don't take interest rate risk," said William Housey, Senior Portfolio Manager for First Trust Advisors. "We take credit risk because the company could default if they can't meet their obligation. We require companies to secure the loans with their assets in the event of bankruptcy. Senior loans recover 80 cents on the dollar in the event of default."

A Greenwich Associates study found that ETFs are gaining traction in fixed income with 55% of institutions investing in domestic fixed income ETFs and 74% of registered investment advisors employing ETFs in domestic fixed income.

"As decreased fixed income bond liquidity has driven institutional investors to explore new ways to access fixed income markets, fixed income ETFs are increasingly being used by investors to access liquidity and implement investment strategies," said Matthew Tucker, head of iShares fixed income investment strategy at BlackRock.

Competing ETFs include Power Shares' Senior Loan Portfolio (BKLN), which was the first bank loan fund launched in March 2011 and State Street's SPDR Blackstone GSo Senior Loan ETF (SRLN) and Highland/iBoxx Senior Loan ETF (SNLN). BKLN is the biggest bank loan fund with inflows of $3.8 billion and a 10.2% return in 2012, according to Morningstar.

The downside of bank loans is they are relatively illiquid and have been difficult to trade in the past. "There was a concern about putting them in an ETF format, because it requires daily liquidity and intra-day trading, but as the market has become more liquid in the last few years, and all these funds have provisions that create additional liquidity if the market gets volatile," said Timothy Strauts, an ETF analyst with Morningstar.

Powershares, for example, established a credit line for short term needs if ever BKLN experienced a large redemption that would require paying out investors.

"BKLN showed how successful it could be and now everyone else is coming in," Strauts said. "As for First Trust's new product and the bank loan category overall, as long as there is not an impending recession. You'll get 4 to 5% returns."

Rising rates hurt the prices of fixed-rate debt, such as lower-yielding investment-grade corporate bonds. But loans have floating interest rates so investors are protected and make more if rates go up.

"There's almost no upside in fixed income today, and there's significant downside so you have to find other ways to generate income in alternative strategies, like high yield long short and floating rate senior loans," concluded Housey.